Seeds of credit crunch grow in LBO loan market

NEW YORK (Reuters) - Investors looking for signs of a crack in the credit markets are turning their attention to a corner of the debt market that's been feeding the leveraged buyout frenzy.

Banks used to finance buyouts mainly with loans on their balance sheets, but are now packaging and selling that debt to investors using instruments called "collateralized loan obligations" (CLOs) that group various loans together to diversify risk.

For example, debt issued by the $5.6 billion private-equity purchase of rental company Hertz (HTZ.N) is now in the hands of more than 200 CLOs. Similarly, HCA Inc's debt from the buyout of the hospital chain for $21 billion went to 58 CLOs, according to Morgan Stanley (MS.N).

But investors are becoming concerned that a deterioration in credit quality, or the recent rise in U.S. Treasury yields, might force a re-evaluation of some portfolios causing defaults such as occurred in the subprime mortgage sector in the U.S. in the past year.

In the old days of relationship banking, banks relied on credit quality control and huge balance sheets to ride out any problems, but CLO investors may be more short-term oriented.

Lack of credit quality control by some managers of CLOs is particularly frightening to veteran private equity investors.

"What all of this will show -- and it will show more as CLOs become more popular -- is that risk management has not been very well practiced," said billionaire financier Wilbur Ross, founder of private equity firm WL Ross & Co. "That's going to hurt a lot of people, and will ultimately explode the bubble."

Ross cited an example of a fund manager who bought a $20 million chunk of debt from one his portfolio companies but did not bother to show up to a due diligence meeting. The fund manager did not think the chunk was big enough to worry about, Ross said.

At the very least, there are concerns that the credit tap may get turned off, if weaker hands fold and CLO values drop.

At the worst, it could turn into a rout that forces investors to sell other securities, hurting markets broadly.

"You have the potential for there to be a broader meltdown," said the CEO of a firm that does both private equity and hedge fund investing, who declined to be identified.

"The problem is there's not a well capitalized individual on the other end of the phone. It's just an investment vehicle and that creates the possibility of a lot more volatility."

TWO-EDGED SWORD

For the credit markets, it's a double edged sword.

The diversified instrument that's helped fuel the leveraged buyout boom in recent years could also be the source of its collapse.

Indeed, some private equity professionals believe that CLOs will not only be the likely culprit that sparks a credit crunch, but will also speed up the impact.

CLOs are similar to mutual funds in grouping together various securities to diversify risk. Investors can choose how much risk to take, and their returns are ratcheted accordingly.

Collateralized Debt Obligations (CDOs), a broader classification of the structures, can contain debt ranging from risky subprime home mortgage loans to junk bonds to higher-rated investment-grade debt.

Managers of CLOs can be large global, institutional investors or small as one person operations. Hedge funds, which buy and sell securities, have also been reliable buyers of leveraged buyout debt. But CDOs have been especially voracious buyers of CLOs.

Total CDO sales grew to more than $300 billion in the United States last year, a record, doubling in size in less than two years, according to Thomson Financial.

Loans for non-investment grade companies climbed to $612 billion in 2006, surpassing the record $500 billion in 2005, which was double levels seen in 2000.

The rise of CLOs has coincided with the private equity wave that began building around three years ago. Private equity firms typically buy and sell companies by borrowing 70 percent of the money. Low borrowing costs and a steady economy have fueled the largest leveraged buyout boom to date, with more than $400 billion of deals in the first half of this year alone, more than triple the amount in the year ago period.

Meanwhile, corporate borrowers are lining up to issue even more debt. Payment processor First Data Corp. FDC.N is preparing a record $16 billion in loans to fund its $24 billion leveraged buyout.

Upcoming debt sales may prove the tipping point for market sentiment. Canceled deals or a lack of buyers could puncture investor confidence, pushing record low default rates higher.

The end result would be a swift reaction by CDOs, CLOs and hedge funds, which would lead to the long-awaited drying up of credit.

"You're close to the peak of the cycle," said Anton Schutz, a portfolio manager at Mendon Capital, which focuses on financial firms.

"For new CDOs coming to market, the end buyers are going to say, 'I just took a loss on these things and you want to sell me more?' They'll want to know more about what's in this paper."

(Additional reporting by Dan Wilchins)